Calculated risks for satisfying returns

Prior to financial deregulation, fund management was an area relatively untouched by the banking industry. But over the last decade or so, this area has been actively pursued by the industry in an effort to diversify their sources of profits beyond the traditional deposit taking and loan provision. As they move into fund management, banking techniques such as value-at-risk (VAR) naturally begin to cross over into the funds management. Before we look at how risk management can be applied to funds management, it is useful to understand the differences between banking and fund management.

Banks tend to price their products on a per transaction basis while fund managers base their fees on funds under management. This means that profits to banks can be lumpier than for fund managers, as transaction levels are tied to the economic cycle. Banks are concerned about protecting their capital, as they have a depositor base to protect. So, profits and risks are measured and managed on a daily basis. On the other hand, investors generally invest with a fairly long time frame in mind - fund managers are expected to out-perform over longer periods.

While there are differences, people in banking and fund management need to understand the risks associated with their underlying exposure. Banks are interested in shorter-term risk, and want to control their risk exposure. The returns should be commensurate with the risk taken. Similarly, fund managers need to know that portfolio returns are commensurate with the risk taken. Fund management risk is heavily based on under-performance against the appropriate benchmark. Investors tolerate under-performance but only up to a point. Protection of capital is not such an issue, because investment in volatile assets such as equities can mean losses as well as gains.

The first building block of risk management in funds management is to have timely, accurate and reliable accounting marketing and book values as well as exposure data. This is the market value data adjusted for the effects of instruments such as futures, forwards, and options - one can break up the derivatives into its underlying components. The second building block is the availability of accurate and timely performance measurement.

Performance measurement helps maintain quality control and the discipline of the process: it shows whether the process is working – continual under-performance may be an early warning signal; provides quantitative tools to monitor compliance issues; allows management to objectively reward good fund managers, and provides information to investors and regulators. Performance attributions can be carried out on portfolios to identify sources of over or under-performance of a fund manager.

The third building block of risk management is to use the performance data to calculate historical risk measurement information. This will assist management to understand whether fund managers took appropriate risk levels to produce the returns. The fourth building block of risk management is a measure of prospective risk. It is a common practice in the investment world to concentrate on ex-post risk measures. However, they suffer from being hindsight measures. It can also be difficult to separate ‘signals’ from the ‘noise’, because these hindsight measures are based on say, 36 historical monthly returns. It is not clear how much of that past history is relevant, or whether a longer period should be used.

One such ex-ante, prospective measure of risk inherited from banking is the VAR methodology. Measures such as duration and beta are asset-class specific whereas VAR offers an overall framework for risk disclosure. VAR is useful to quantify the risk tolerance for each portfolio. It provides prior warning of whether a position or a set of positions is capable of exceeding this risk tolerance. This helps identify market shifts or mismanagement before the fact and is particularly useful, when managing a client’s several portfolios, to assess the likely impact of risk concentration.

There are also operational risk issues that can probably only be measured by the lack of claims due to transactional errors. These risks can be controlled via strong compliance procedures. For example, credit risk to counterparties can be monitored, and fund managers should have their responsibilities clearly set out in clear and up-to-date mandates.

Fund management, like banking, needs a clear understanding of the risk involved in achieving a given return. This provides additional control over the process, and helps maintain comfort and safety levels. The process of risk management can be built up, as the sophistication of the fund manager increases.

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Last Update: 10:27 16/06/97